Reducing Buyer Search Coss: Implicaions for Elecronic Markeplaces J. Yannis Bakos Sern School of Business, New York Universiy 44 Wes 4 h S, New York, NY 1001 (email: bakos@sern.nyu.edu; web: hp://www.sern.nyu.edu/~bakos) Managemen Science, Vol. 43, No. 1, December 1997 ABSTRACT Informaion sysems can serve as inermediaries beween he buyers and he sellers in a marke, creaing an elecronic markeplace ha lowers he buyers' cos o acquire informaion abou seller prices and produc offerings. As a resul, elecronic markeplaces reduce he inefficiencies caused by buyer search coss, in he process reducing he abiliy of sellers o exrac monopolisic profis while increasing he abiliy of markes o opimally allocae producive resources. This aricle models he role of buyer search coss in markes wih differeniaed produc offerings. The impac of reducing hese search coss is analyzed in he conex of an elecronic markeplace, and he allocaional efficiencies such a reducion can bring o a differeniaed marke are formalized. The resuling implicaions for he incenives of buyers, sellers and independen inermediaries o inves in elecronic markeplaces are explored. Finally, he possibiliy o separae price informaion from produc aribue informaion is inroduced, and he implicaions of designing markes promoing compeiion along each of hese dimensions are discussed. Copyrigh 1997 by The Insiue of Managemen Sciences Keywords: elecronic markes, search coss, consumer search, elecronic commerce, Inerne markes
1. Inroducion The 1990s have seen an explosive growh of neworks and informaion sysems ha cross organizaional boundaries. These sysems ofen can bring ogeher buyers and sellers in a marke, as has been he case, for example, wih airline reservaion sysems. The resul is an elecronic marke sysem, or elecronic markeplace (e.g., Bakos 1987, Malone e al 1987). The sraegic poenial of hese sysems has been demonsraed in several indusries (e.g., see Bakos 1991 for a general discussion and Hopper 1990 for a discussion of he impac on a specific indusry). The imporance of elecronic markeplaces is dramaically increasing, however, as inerorganizaional neworking becomes widely available hrough high speed digial elecommunicaions services and he Inerne, encompassing hundreds of housands of businesses and millions of individual consumers. This rend is furher amplified as he cos of paricipaing in an elecronic markeplace is lowered by emerging public and privae sandards for access and informaion exchange over he Inerne, such as he hyperex markup language (HTTP) proocols, he secure sockes layer (SSL) archiecure for secure informaion exchange, and CommerceNe s (www.commerce.ne) suie of sandards for elecronic commerce. In he conex of his aricle, an elecronic markeplace or elecronic marke sysem is an inerorganizaional informaion sysem ha allows he paricipaing buyers and sellers in some marke o exchange informaion abou prices and produc offerings. We focus on he role of hese elecronic markeplaces in bringing ogeher buyers and sellers in seings such as airline reservaion sysems, Inerne-based elecronic sorefrons, or financial markes. We are no concerned wih ransacion-oriened benefis realized afer a bilaeral relaionship has been esablished, 1 or wih elecronic daa inerchange (EDI) or elecronic paymen sysems which are primarily ransacion-oriened. Furhermore, while elecronic markeplaces affec several oher parameers of commerce, such as securiy, privacy, selemen, ec., his paper focuses on he impac of lower search coss. This definiion of elecronic markeplaces is subsanially narrower han he view of elecronic markes as informaion-echnology based governance mechanisms (e.g., Malone e al 1987), or as coordinaion mechanisms (Malone and Crowson 1994). Specifically, his aricle sudies he marke-making funcionaliy of elecronic markeplaces during he processes of price discovery and idenificaion of appropriae produc offerings in a marke. 1 For insance, real-world sysems ofen offer such benefis beyond heir marke-relaed funcionaliy, e.g., airline reservaion sysems offer billing, iinerary and icke prining funcions and financial marke sysems may suppor ransacion selemen; however hese feaures are separable from he marke inermediaion process, and heir value is added afer he maching of a buyer and a seller has aken place. Page 1
The aricle is organized as follows: Secion briefly reviews commodiy markes, where elecronic markeplaces can promoe price compeiion among sellers by increasing he availabiliy of price informaion; in his scenario, moving a marke on-line can have a dramaic impac on seller profis and buyer surplus. Mos markes, however, are characerized by heerogeneous consumer ases and a variey of produc offerings. The role of elecronic markeplaces in hese markes is more complex, as buyers need o obain informaion abou produc characerisics as well as prices. Secion 3 analyzes he role of search coss in a marke wih heerogeneous produc offerings and consumer ases by inroducing search coss in a spaially differeniaed marke. In his seing, buyer search coss can resul in subsanial allocaional inefficiencies and sellers can exploi hese search coss o exrac monopolisic rens. I is shown ha reducing he cos of price and produc informaion ypically will improve marke efficiency bu will reduce seller profis. By reducing search coss, elecronic markeplaces may enable he emergence of new markes or preven he breakdown of exising ones. Secion 4 addresses he impac of elecronic markeplaces on he invesmen incenives of buyers and sellers, which may lead o underinvesmen by sellers and overinvesmen by buyers. Secion 5 inroduces he possibiliy o separae buyer search coss ino heir componen coss of searching for price informaion and searching for produc informaion, and explores he implicaions for he design and impacs of elecronic markeplaces. Finally, Secion 6 discusses some implicaions of elecronic markeplaces for he srucure and efficiency of marke-mediaed ransacions and oulines and agenda for furher research.. Elecronic Markeplaces and Search in Commodiy Markes In commodiy markes, all sellers are assumed o offer idenical producs; hus he role of an elecronic markeplace is o provide informaion abou he exisence and he price of a seller. There is a well developed lieraure on buyer search in commodiy markes, wih Diamond (1985) and Sigliz (1989) providing excellen reviews. Inroducing a search cos in he radiional models of commodiy markes can resul in monopolisic pricing by he sellers 3. Thus even modes search coss can lead o prices subsanially higher han marginal coss, even when sellers do no behave collusively in commodiy markes. In his aricle we adop he sandard definiion of buyer search cos in he economic lieraure as he cos incurred by he buyer o locae an appropriae seller and purchase a produc. This would include he opporuniy cos of ime spen searching as well as associaed expendiures such as driving, elephone calls, compuer fees, magazine subscripions, ec. 3 This is a sandard resul in mos search models in he lieraure, as noed by Diamond (1985) and Sigliz (1989). Page
Elecronic markeplaces providing price informaion will reduce he incremenal cos of obaining informaion abou addiional sellers and hey may also reduce he abiliy of sellers o obscure heir quoed prices (e.g., by including or excluding ransporaion coss, incenives, special promoions, financing coss, ec.) In ha respec, elecronic markeplaces are likely o move commodiy markes closer o he classical ideal of a Walrasian aucioneer where buyers are coslessly and fully informed abou seller prices. Since he assumpion of fully informed buyers leads o he compeiive price-aking equilibrium in he classical marke model, and i underlies resuls such as Berrand s zero-profi equilibrium in oligopolisic seings, we expec ha elecronic markeplaces ypically will sway equilibria in commodiy markes o favor he buyers, will promoe price compeiion among sellers, and will reduce sellers marke power. If elecronic markeplaces lead o a large enough reducion in search coss, hey may desabilize profiable oligopolisic pricing in a commodiy marke and insigae price wars ha wipe ou any excess profis enjoyed by he sellers. This is no surprising, as a commodiy produc bough from differen sellers can differ only in is price. As elecronic markeplaces make he disribuion of informaion more efficien, he opporuniies for fa and easy profis will shrink. Sellers may aemp o delay he arrival of such sysems, or may ry o conrol hem. For example, a he Eurobond marke s 1987 annual meeing in Oslo, Salomon Brohers led he major American rading firms in successfully opposing proposals for a compuerized price-quoaion sysem for he rading of Eurobonds (Economis 1987). Such a sysem would make marke informaion available insanly o all subscribing invesors and raders, regardless of heir size or locaion, and could mark he end of big rading profis as bonds of similar credi raing, ineres rae and mauriy are virually inerchangeable commodiies. Indeed, dealers were able o resis and delay he inroducion of such sysems ino he mid-1990s, even in he face of pressure from governmen regulaors. 3. Elecronic Markeplaces and Search in Differeniaed Markes Alhough cerain markes involve commodiy producs, like governmen bonds or mos agriculural and mineral producs, mos markes are characerized by differeniaed producs. The prevalence of differeniaed markes is a resul of he heerogeneiy of buyer preferences and he profi opporuniies hese markes offer o sellers. Differeniaed markes involve a variey of produc offerings and consequenly he search problem buyers face in hese markes becomes complicaed by he need o consider boh he price of a paricular seller and he characerisics of he corresponding produc offering. Elecronic markeplaces in differeniaed markes will herefore need o provide boh price and produc informaion, o enable he comparison of differen produc offerings. While Page 3
price informaion is relaively easy o convey, providing adequae produc informaion poses a challenge ha sysem designers have been rying o address since he early days of such sysems. For example, a cenral feaure of boh he American Gem sysem, used for he rading of precious sones, and he AucNe sysem, used for he rading of used cars, was he provision of a sandardized raing sysem for he qualiy of he iems feaured on he sysem s elecronic marke (HBS Case Sudies 1988, 1989). The increasing muli-media capabiliies in he Inerne, which now allows he ransmission of high resoluion images, video and hree-dimensional virual environmens, creae unprecedened opporuniies for he design of elecronic markeplaces ha effecively convey produc informaion a reasonable cos. Economiss have been ineresed in differeniaed markes since he lae 190's, and have proposed wo major ypes of models for heir sudy: spaial differeniaion models racing heir origin o Hoelling's (199) formalizaion of spaial compeiion, and brand subsiuion models whose origin is ofen aribued o Chamberlin (1933). In spaial differeniaion models, like he one developed in his secion, brand aribues are reaed as choices of locaion in a muli-dimensional space. A consumer's preferences deermine he locaion of her ideal produc or produc mix, and some ype of disance meric in he produc aribue space is used as a proxy for he uiliy loss, or fi cos, when a consumer is no able o purchase her ideal brand or a perfecly subsiuing mix of brands. These models highligh he imporance of brand aribues (produc offerings) and he dynamic aspecs of compeiion hrough he reformulaion of exising brands or hrough he inroducion of new ones (Schmalensee 1978, Perloff and Salop 1985). 3.1. A Model of Search Coss in Differeniaed Markes Diamond (1985) noes ha search heory and empirical work have a long way o go unil we have saisfacory answers o a number of allocaion quesions ha are oally ignored in a Walrasian seing. Nohing has been done o marry he underlying search issues wih some of he realiies of he geographic disribuions of consumers and firms and very lile has been done o model he search basis for he role of inermediaries. This secion addresses hese issues by inroducing search coss o a uni circle or ciy around he lake seing, similar o Salop s (1979) model of spaial differeniaion. Specifically, in a world wih differeniaed produc offerings along a uni circle, as shown in Figure 1, a buyer is required o pay a search cos o find he locaion (i.e., he produc characerisics) and he price offered by some seller, and hen decides wheher o purchase Page 4
m sellers n buyers Figure 1: A model wih produc differeniaion one of he producs already idenified or o keep searching. 4 The disance beween a buyer s ideal produc and he locaion of an acual produc offering imposes on he buyer a fi cos, which represens he loss of uiliy from obaining a less han ideal produc. We find ha in his ype of seing, an elecronic markeplace providing buyers wih low-cos produc and price informaion can generae subsanial allocaional efficiencies by enabling hese buyers o locae sellers ha beer mach heir needs. 5 Model 1 Consider a marke wih n buyers and m sellers for a good ha is spaially differeniaed along a single dimension, represened by a uni circle. Buyer ases are heerogeneous and uniformly disribued along his uni circle, and seller offerings are differeniaed along he same dimension. If buyers purchase a good ha does no perfecly mach heir ase, hey incur a fi cos per uni of disance beween heir locaion on he circle and he locaion of he seller offering hey purchase; his cos represens heir uiliy loss for acquiring a good differen from heir ideal one. All buyers have idenical uni demand in each period, subjec o a reservaion uiliy r. They are risk neural, and hey will ener he marke if hey expec he oal cos of heir purchase o be less han or equal o r. Sellers are risk neural as well, 4 The choice of a uni circle seing simplifies he analysis bu does no subsanially affec he resuling equilibria; similar resuls will be obained in linear models like Hoelling s. 5 I should be noed ha his analysis is enirely differen from inerpreing he ransporaion cos in Salop s (1979) and oher similar models as a search cos, like he cos of visiing a seller known o carry a desirable produc. Such an inerpreaion would force he search cos o be he only differeniaing characerisic of differen producs, reducing he seing o a commodiy marke wih search coss. The model developed in his secion allows producs o be differeniaed independenly from he cos of obaining informaion abou heir characerisics, which is essenial in sudying he role of an elecronic markeplace in a differeniaed marke. Page 5
and hey each supply a single good for which hey face a consan marginal cos (assumed for convenience o be zero). Sellers move firs by deciding where o locae heir produc offerings and how o se heir prices. All sellers seem ex ane idenical o buyers, as buyers have no prior knowledge of he locaion along he uni circle or he price of seller offerings. 6 Each buyer can learn he price and locaion of he produc offering of an addiional seller (up o he m-h seller) by paying a consan search cos c. A his poin he buyer mus decide wheher o purchase from one of he sellers whose produc/price characerisics have been discovered, or o inves in informaion abou an addiional seller by incurring he corresponding search cos c. This defines he buyers sraegy space. To simplify he analysis, we assume ha buyers sample he sellers wih replacemen, which means ha buyer priors do no change afer each addiional inquiry. 7 The number of sellers m is common knowledge, resuling in buyer priors ha here is a seller wih probabiliy m.dx along any differenial segmen of he uni circle wih lengh dx; le f denoe he buyers prior disribuion for seller prices. Finally, sellers canno observe he locaion of visiing buyers, and hus canno price discriminae. In his seing, we explore he exisence of Perfec Bayesian Equilibria, i.e., perfec equilibria ha saisfy he raional expecaions consrain ha f is he acual disribuion of seller prices. 8 Analyzing a single period seing also means ha we ignore he effecs of repuaion. Alhough his may be unduly resricive in cerain economic relaionships characerized by repeaed ineracions beween he same agens, i is ypical for models in search heory 9 because i simplifies he analysis by resricing aenion o equilibria in he one-period sage 6 This assumpion implies ha as he number of sellers increases, i becomes commensuraely less likely o land on any specific seller, which may no hold if buyers can direc heir search oward (or away from) cerain produc characerisics. The implicaion seems in line, however, wih he experience of rying o locae sellers on he Inerne, where search engines like Ala-Visa reurn long liss of poenially relevan sies. 7 This assumpion does no significanly affec buyer behavior as long as he number of inquiries a equilibrium is much smaller han m. I also does no affec seller behavior as sellers canno adjus heir price and produc offering in response o buyer search hisories. In he case where buyers adjus heir priors afer each inquiry, he qualiaive naure of he resuls does no change, and our model marginally underesimaes buyer welfare in he resuling equilibrium (also see foonoe 14). 8 This seing could be hough of as he sage game for a repeaed game. Since here is no sae variable o affec play in subsequen periods, he equilibria derived for he one-period game rivially exend o Markov perfec equilibria for he muli-period game, i.e., equilibria ha depend only on paricular saes of he marke and no on pas hisory. 9 Diamond (1985) noes ha "all he models [reviewed] omi or severely limi price repuaions. This is a major hole in he exising lieraure. Significan progress in his area will probably have o awai he discriminaion of cases in which opimal sraegies are saionary, from hose in which opimal sraegies involve building up a repuaion which is hen run down." While sudying he role of repuaion in noncooperaive siuaions is a very complex underaking (e.g., see Fudenberg 1991) and would disrac from he hrus of his aricle, repuaion issues as hey relae o marke paricipans and inermediaries are clearly imporan and presen an ineresing area for fuure research. Page 6
game. The assumpions of consan search coss and inelasic buyer demand are no crucial, and he analysis sill holds for increasing marginal cos of search and for elasic bu idenical buyer demand funcions. If he cos of search is zero, his seing is similar o he one analyzed by Salop (1979), and, as shown here, he unique equilibrium requires all sellers o charge a price p*=/m. In he presence of search coss, however, he equilibrium dynamics change. Ineresingly, for a large enough number of sellers, m, he equilibrium price does no depend on m, while i depends on boh he degree of differeniaion and he search cos c. Equilibria A buyer wih prior f for he disribuion of seller prices, and who has already locaed a mos desirable offering a price S and disance D along he uni circle, which we denoe wih he pair (S, D), will only buy from sellers in he inerval [ D S/, D+S/ ] relaive o ha buyer s locaion. 10 If a seller in ha inerval locaed a disance x offers price p, he buyer faces a price of p+x (adjused for fi ), and will be willing o purchase if p+x < S+D. Thus, a buyer's expeced gain from searching for one more seller is given by I S + - gsd (, ) = ( S+ D-x- p) f( pdpdx ), which can be wrien as I x D S = + I 0 p = 0 D x + - gsd (, ) = F( pdpdx ) x D S = + I 0 S p = 0 D x As g(s,d) is sricly increasing in S+D, a any Perfec Bayesian Equilibrium buyers will keep searching if and only if g(s,d)>c, i.e., hey will se a reservaion price R=R(c,,f) for S+D, and keep searching if S+D>R. This reservaion price is idenical for all buyers by symmery, and is value does no change as searches do no change buyers priors. Since buyers adop reservaion price sraegies, any seller ha raises is price will price ou marginal buyers increasingly closer o ha seller s locaion on he circle. As a resul, each seller faces a downward sloping demand curve and a sricly decreasing marginal revenue curve, which resuls in a unique price p* for ha seller ha maximizes is expeced profis. Consequenly sellers will only adop pure sraegies a equilibrium: any mixed sraegy ha requires a seller o charge a price p p* wih posiive probabiliy is dominaed, since he (1) 11 10 This is because a seller ouside ha inerval could no arac he buyer even wih a price of zero. 11 The resul for he inner inegral is derived as follows, wih R=S+D x and using inegraion by pars: R R (R p)f (p)dp = (R p) df(p) 0 dp dp = p= R p= R R R (R p)df(p) = 0 [(R p)f(p) ] p=0 p=0 + F(p)dp = F(p)dp 0. 0 Page 7
seller could increase is profis by disconinuing price p and correspondingly increasing he probabiliy of charging p*. 1 Furhermore, seller prices will be symmeric: he principle of maximum differeniaion applies as in Salop (1979), requiring all sellers o posiion hemselves symmerically around he uni circle and charge an idenical price p*. 13 To deermine he price charged, consider such an equilibrium wih p = p* for all sellers, i.e., F(p)=0 for p<p* and F(p)=1 for p p*. Then Equaion (1) implies ha I D+ S gsd (, ) = ( S+ D p* xdx ), where he inegrand canno assume negaive values, i.e., x= 0 I S p * + D 1 x D + ( S p*). Thus g( SD, ) = ( S+ D p* xdx ) = ( S+ D p*) x= 0 gsd (, )= cgives 1 ( S + D- p*) = c, i.e., \ S + D = p* + c (). and solving According o equaion () each seller receives sales from an inerval - c, c around ha seller s posiion. Tha inerval is of lengh c, and we refer o i as ha seller s erriory. Similarly, each buyer is willing o buy from sellers in an inerval - c, around ha buyer s posiion, which we refer o as ha buyer s neighborhood. 14 If seller erriories and buyer neighborhoods are of lengh l, hen a given seller ges he business of hose of he ln buyers in is erriory who visi ha seller before hey visi any of he oher lm sellers in heir neighborhood, and hus on expecaion sells o n/m buyers. c 1 Sellers would never resor o mixed sraegies in order o affec buyers reservaion prices, eiher; higher variance in seller prices can only lower buyers reservaion price. 13 If sellers canno observe oher seller offerings before choosing heir spaial locaion, hey will sill be uniformly disribued on expecaion. If hey can observe oher seller offerings afer choosing heir locaion bu before choosing heir price, he resuling equilibrium will no be symmeric, wih higher prices in hinly populaed (less compeiive) areas on he circle. However, he impac of search coss remains qualiaively similar o our analysis and he wo models converge as he number of sellers increases. 14 In he case of search wihou replacemen, buyers will adjus heir priors afer each inquiry, increasing he probabiliy ha a desirable seller offering will be discovered in he nex search, given ha a number of unaccepable ones have been locaed so far. Specifically, on he k-h search he equilibrium condiion in equaion () becomes m 1 1 (S + D + p*) = c, leading o decreasing reservaion prices m k R k = p *+ m k c, and correspondingly shrinking buyer neighborhoods. The impac of changes in search m 1 coss on he equilibrium oucomes will be qualiaively similar, and if m is large enough so ha (m 1)(m k) says close enough o 1, he models will converge. Page 8
A equilibrium, any seller i is maximizing profis aking oher sellers price as given, and hus has no incenive o deviae unilaerally by charging a differen price, i.e., d dp i! pq p p i i( i, * j i) = 0 $# pi = p* where Qi( pi, p* j i) denoes he sales of seller i when he price charged by i is p i while every oher seller j i charges price p*. Thus d Q p p p dp Q p p i( *, * i j i) * i( i, * +! j i) = 0 (3). $# pi = p* i A deviaion by seller i of dp i =-δ, i.e., charging a discoun price of p* δ, resuls in an increase of δ/ in i's erriory, and new sales of " " c δ + c n m = 1+ δ c n m. Thus: n dpi dqi( p*, p* δ i j i) = = - cm c d \ dp! Q p p i( *, * i j i) " $ # =- 1 c i n m n m (4). Since Q( p*, p* ) = n m, i follows from equaions (3) and (4) ha: i i j i n m p 1 n - * = 0 c m \ p* = c (5). Thus a he unique symmeric equilibrium each seller charges price p* = c and buyers reservaion price is R = p*+ c = c. Each buyer searches unil a seller wihin disance c is locaed, i.e., heir neighborhood is of lengh c. Each search is a Bernoulli rial wih success probabiliy c, and an accepable seller will be locaed afer 1 1 1c6 - rials Page 9
on he average, incurring expeced search coss of 1 cc 1 1 6 - = c. The bes seller locaed will be on he average a a disance of 1 c, resuling in an expeced fi cos of 1 c = 1 c. Given ha he buyer pays a price of c, he buyer s expeced uiliy is r c. 1 If he number of sellers is large, in he absence of search coss each buyer will be mached o is ideal seller and he Berrand-like equilibrium is characerized by zero seller profis and correspondingly low allocaional inefficiencies ( fi coss). When search coss are inroduced, each buyer incurs a loss of c because of search coss and he disuiliy of purchasing a less-han-ideal produc offering (he fi cos), resuling in a oal inefficiency of n c. 3.. Elecronic Markeplaces Can Preven Marke Failure The above discussion assumes ha r c, i.e., buyers reservaion uiliy is high enough so ha no buyers are priced ou of he marke. If c > r c, hen sellers find ha heir sales (and profis) disappear when hey charge a price above r c, and he unique equilibrium requires sellers o charge price p*=r c. Finally if r < c, buyers will say ou of he marke even if hey are offered a zero price; hey would find i oo cosly on expecaion o locae an accepable seller, even hough for a large enough number of sellers such a seller is guaraneed o exis. Thus, high search coss can lead o a marke breakdown. This resul illusraes he imporance of search coss and he difference of our seing from similar seings wih free informaion; in Salop's (1979) model, for example, sellers will always service heir local markes, even if some consumers are priced ou because of high ransporaion coss. Figure shows he impac of increasing search coss on seller prices. By reducing search coss, elecronic markeplaces can preven his ype of marke breakdown. Similarly, hey may enable he creaion of new markes ha were no previously possible because of high search coss. The resul of marke breakdown holds for markes wih few sellers as well, where model 1's assumpion of sampling wih replacemen could be unrealisic. To illusrae his, consider a seing similar o model 1, wih a large number n of buyers bu wih only wo sellers, locaed a diamerically opposed posiions (see Figure 3). If buyers sample wihou replacemen, hey can anicipae he resul of heir second search, since hey can deduce he prices and produc offerings of boh sellers from heir knowledge of he corresponding probabiliy disribuions. Assuming no collusion beween he sellers and ha no buyers are priced ou of he marke, all buyers would search a leas once. If he search produces a produc offering a a disance x Page 10
price r surplus per buyer inefficiency per buyer r 0 r 4 r buyer search cos marke breakdown Figure : The impac of increasing buyer search coss higher han 1 + c 4, buyers will search once again o locae a produc a a disance 1 - x, which is less han 1 - c, and hus is worh he addiional search cos c. Buyers a a disance 4 less han 1 - c 4 from heir neares seller will search eiher once or wice (unil hey locae heir neares seller), wih an expeced search cos of 1.5c. The remaining buyers will search only once, a a cos c. A equilibrium each seller sells o n/ buyers, and discouning by δ increases individual sales by nδ/; he equilibrium price p* mus herefore saisfy n nδ δ = ( p *-δ) in he limi as δ 0, and hus p* = 4. If he sellers charge a price p, a buyer s expeced uiliy (inclusive of search and fi coss) by I1 c + x= 0 I1 c x= 0 4 4 enering he marke is r p c xdx ( x + c) dx. The firs hree erms ake accoun of he buyer s reservaion price, price paid and cos of he firs search; he firs inegraion accouns for he expeced cos of fi if he buyer purchases from he firs seller discovered, and he second inegraion accouns for he expeced cos of fi if a second search is necessary, including he addiional search cos. Calculaing he above expression gives us 3c c an expeced uiliy of r- p- - + (provided ha c < ). If c >, hen buyers will 8 search only once, incurring an expeced fi cos of : he second search would be oo 4 Page 11
1 c 4 seller 1 c 1 + c 4 c 1 c 4 seller sellers n buyers Figure 3: A differeniaed marke wih wo sellers expensive even if i would produce a seller wih perfec fi. I follows ha buyers will paricipae in he marke if 3c c p r- - + if c 8 p r-c- if c > 4 (6) I can be seen from Equaion (6) ha even in a marke wih only wo sellers where buyers search wihou replacemen, large search coss will cause a marke breakdown. This is he case even if buyers wih preferences close o he seller offerings could have been profiably serviced ne of search coss. This propensiy of differeniaed markes o break down when search coss are high opens he possibiliy ha elecronic markeplaces will enable missing markes, hereby creaing subsanial social surplus. For example, unemploymen migh be parially explained as a marke failure caused by he cos of obaining informaion abou available produc offerings (job opporuniies) offered by sellers (poenial employers). A any given ime, cerain workers are in he process of searching for an appropriae job. Oher workers face high search coss relaive o heir reservaion price, and hus say ou of he job marke because heir paricipaion is unprofiable on expecaion. Finally, oher workers may be misinformed abou he available job opporuniies, having unrealisic expecaions and seing a high hreshold for heir search, corresponding o a small neighborhood in model 1). Such misinformed workers will ake oo long o find jobs, and will hus increase he observed level of unemploymen. Page 1
An elecronic markeplace maching skills wih posiions could reduce he above hree componens of unemploymen, by reducing he cos faced by workers exploring job openings (including he ime of each search). I could also resul in a more efficien maching of worker skills o job openings. Indeed, as he Inerne reduces he cos of seing up elecronic markeplaces in he job marke, elecronic job lisings have grown from only abou 15,000 in 1994 o half a million in mid-1996 (Markels 1996), wih a leas 10 major on-line job banks emerging. There is anecdoal evidence ha by reducing search coss, hese sysems boh decrease he ime spen searching and allow job seekers o find jobs hey would no have searched for oherwise. 15 A reducion in unemploymen even by a small fracion as a resul of elecronic markeplaces in he labor markes could offer large economic benefis. 3.3. Elecronic Markeplaces Benefi Buyers Model 1 shows how buyer search coss allow sellers offering differeniaed producs o heerogeneous buyers o exrac monopolisic rens. This analysis provides formal suppor for he proposiion ha elecronic markeplaces promoe price compeiion and reduce he marke power of sellers, as has been argued by several auhors (e.g., Bakos 1991, Clemons 1991, Malone e al. 1987). As elecronic markeplaces reduce he search coss of buyers o obain price and produc informaion, hey resul in decreased price premiums and seller profi margins. The opimal sraegy for a buyer in a marke wih search coss is o deermine a price and fi hreshold, and keep searching unil a saisfacory produc is locaed. Cusomers wih access o elecronic markeplaces, and hus facing lower search coss, become more demanding and are willing o make fewer compromises concerning heir ideal produc. If he cos of search is low enough, buyers look a all produc offerings and purchase he one bes serving heir needs, resuling in a socially opimal allocaion. Buyers are made beer off from such a sysem in hree ways: firs, hey enjoy lower prices because of he increased compeiion among sellers; second, and equally imporan, hey enjoy allocaional efficiencies from being beer informed abou he available producs, hus making beer purchasing decisions; finally, hey incur lower oal search coss, even hough hey increase heir number of inquiries. While lower prices come a he expense of seller profis, beer allocaion and reduced search coss increase he ne social surplus. High search coss, on he oher hand, no only lead o efficiency losses, bu may cause a marke o break down, or may preven i o arise in he firs place. 15 For example, according o a esimonial in (Markels 1996), The Inerne absoluely decreased he ime I spen on unemploymen. Suddenly I had access o jobs all over he counry, I would never have goen ou of California wihou i. Page 13
4. Invesmen Incenives for Elecronic Markeplaces We now urn o he incenives of buyers, sellers, and independen inermediaries o inves in elecronic markeplaces. These incenives are imporan, as developing elecronic markeplaces requires subsanial invesmens. The analysis in Secion 3 demonsraes ha he impacs of hese sysems on buyers and sellers are subsanially differen. Consequenly, buyers, sellers and independen inermediaries face differen incenives o inves in he required echnology. Model In he seing of model 1 wih n buyers and m sellers, assume ha invesmen x in he developmen of an elecronic markeplace will resul in search cos c = c( x) for acquiring price and produc informaion. We can assume ha dc < 0 since higher invesmen should dx resul in lower search coss, and ha dc > 0 since here mus be diminishing reurns o dx invesmen as c canno be negaive. Socially opimal level of invesmen According o he analysis in Secion 3.1, a equilibrium each buyer incurs on expecaion a search cos of 1 cx ( ) and a uiliy loss of 1 cx ( ) from imperfec fi of he purchased produc offering, for a oal inefficiency of n c( x). A social planner maximizing he oal social surplus would choose invesmen x* ha minimizes x+ n c( x), solving d dx [ n c( x) + x] = 0. Consequenly he opimal social invesmen x* is obained by solving dc( x) cx ( ) =-. For example, if cx ( )= 1, hen x* is given by solving - = - 3 dx n x x nx, 4 and hus x* = n. Under our convexiy assumpions, as he number of buyers in he marke increases, and as produc differeniaion increases, he socially opimal level of invesmen in echnology ha reduces search coss, such as elecronic markeplaces, increases as well. Seller incenives o inves If sellers as a group were o inves in an elecronic markeplace ha reduces he search cos of heir n buyers, hey can be expeced o capure a cerain proporion α ( 0 α 1) of he Page 14
buyers efficiency gains 16. For insance, his could happen by charging buyers a one-ime fee for using he sysem. Airline reservaion sysems, for example, ypically assess a fee for each icke issued ha depends on he number of fligh segmens bu no on he number of searches performed. According o Equaion (5), as long as r c( x), he sellers realize a profi of cx ( ) from each buyer. Thus he sellers will wan o minimize x+ α n cx ( ) -n cx ( ), i.e., hey will choose x o minimize x+ ( α -1) n c( x), which hey can achieve by solving dc( x) cx ( ) =-. I can be seen ha sellers will no inves a he socially opimal level dx ( α -1) n unless hey can compleely capure he buyers surplus ( α = 1 ). If α < 1 and our convexiy assumpions hold, sellers will underinves in echnology such as elecronic markeplaces ha reduces search coss. If α < 0. 5, i can be seen ha sellers would like o selec x such ha dc( x) > 0 ; since no posiive level of invesmen has his propery, his resul implies ha dx sellers will no only fail o inves in, bu will acually resis he inroducion of an elecronic markeplace. Sellers will also face he socially opimal incenives o inves when search coss are so high ha hey limi he prices ha can be charged by he sellers, or cause he marke o break down. For insance, if c r > c, i was shown in Secion 3. ha sellers can only charge a price r- c. As a resul, sellers' choice of invesmen in reducing search coss will minimize x- nr+ n c( x), and hus will saisfy he same condiion d dx [ x+ n c( x) ] = 0 as he socially opimal invesmen x*. Buyer incenives o inves Each buyer benefis from invesing in an elecronic markeplace by enjoying a lower uiliy loss of 1 cx ( ) from imperfec maching, a lower search cos of 1 cx ( ), and a lower price of cx ( ). Thus if buyers as a group were o inves in an elecronic marke reducing heir search coss, hey would choose heir invesmen o minimize x- n c( x), i.e., solve dc( x) cx ( ) =-. Under our convexiy assumpions, buyers would overinves in elecronic dx n 16 If only one or few sellers conrol he operaion of an elecronic markeplace, hey may be able o hold on o a subsanial porion of sysem benefis ( α > 0 ); oherwise compeiion among sellers is likely o pass sysem benefis o buyers, driving α o zero. Evidence from he airline reservaion sysems suggess ha if he number of inermediaries is small, hese inermediaries are able o reap benefis (albei small) even afer several years of operaing heir sysems (Klei 199). Page 15
markeplace echnology. This is because in addiion o he social gains of his echnology, buyers would benefi from ren redisribuion a he expense of sellers. Inermediary incenives o inves An inermediary operaing an elecronic markeplace will be able o charge buyers for access o he sysem up o heir realized savings from reduced search coss and lower prices. 17 Assuming ha he inermediary can capure a fracion α of he benefis generaed as a resul of is marke power and he bargaining srucure of he seing, he opimal invesmen level will minimize x+ α n c( x). Thus, if α > 0. 5 he inermediary will overinves compared o he socially opimal level; if he benefis are equally spli beween he inermediary and he buyers (α = 0. 5 ) hen he inermediary s incenives are socially opimal, while if mos benefis are compeed away (α < 0. 5 ), he inermediary s incenives o inves are less han heir socially opimal level. Inroducion of elecronic markeplaces In he above seing, sellers are made worse of by elecronic markeplaces hey inroduce if α < 0. 5 and hey are always made worse off by elecronic markeplaces inroduced by buyers or independen inermediaries. As a resul, sellers may oppose he inroducion of sysems ha lower buyer search coss. For example, in he summer of 1995, when Andersen Consuling inroduced is Bargainfinder elecronic agen (hp://bf.csar.ac.com/bf) ha scoued he Inerne sies of music CD sores o find he bes seller for a specific CD in erms of price and availabiliy, on-line music reailers resised he idea (Yovovich 1995). Abou half of he foureen iniial paricipaing sellers dropped ou, and several of he remaining ones evenually ook seps o make i more difficul for he Bargainfinder agen sofware o access heir daabases and compare prices. This nascen elecronic markeplace languished as a resul. 18 This argumen may seem a odds wih he observaion ha mos real-world elecronic markeplaces are iniiaed by sellers, especially in indusries concenraed on he seller side. Wha he above analysis suggess, however, is ha sellers have no incenive as a group o 17 An inermediary may also charge sellers for access o an elecronic marke ha allows new buyers o ener he marke. Furhermore, once he sysem becomes operaional, and depending on he inermediary s marke power, i may be possible o exrac rens from he sellers by hreaening o exclude hem from he elecronic markeplace. 18 If an inermediary is able o capure more han half he benefis generaed from is elecronic markeplace, he cooperaion of sellers can be bough wih a ransfer paymen of one half he generaed benefis. In he case of Bargainfinder, he sysem was inroduced as a vehicle o sudy elecronic markeplaces, and did no generae revenues ha could make his opion feasible. Page 16
inroduce an elecronic markeplace, because ha markeplace will reduce heir oal profis. On he oher hand each seller may wan o inroduce such a sysem individually as, if he number of sellers m is large, he revenues ha can be generaed by charging buyers for he use of an elecronic markeplace will exceed he loss of monopolisic rens for ha individual seller. 19 Thus sellers could find hemselves in siuaions resembling he prisoners dilemma: he firs seller o inroduce an elecronic markeplace would be able o capure mos of he generaed buyer surplus (achieving a high α), while if several sysems are subsequenly inroduced, he resuling benefis may be compeed away ( α 0 ) ogeher wih mos seller profis. If a marke is concenraed on he seller side (i.e., m<<n) and if a subsanial par of he generaed buyer surplus can be capured by he sellers (high α), hen each of he m sellers may realize more individual benefis from he sysem han each of he n buyers. Individual sellers may hus have higher incenives o develop an elecronic markeplace, even hough buyers end o be he primary beneficiaries of hese sysems. This is in agreemen wih evidence from he airline indusry, where he elecronic markeplace creaed by airline reservaion sysems seems o have significanly reduced he airlines monopoly power over heir flying cusomers, while, iniially a leas, i generaed profis for hose airlines ha pioneered he inroducion of such sysems (Hopper 1990). Buyers may also face subsanial free rider problems ha inhibi heir invesmen in elecronic markeplaces: if mos of he benefis of hese sysems are evenually compeed away o he advanage of all buyers, hen individual buyers may prefer o free-ride on elecronic markeplaces inroduced by oher marke paricipans. Finally, we saw ha in markes where he search coss are high compared o buyer valuaions, in monopolisic markes, and in markes where sellers have successfully colluded o avoid price compeiion, sellers will be able o capure mos of he buyer surplus generaed by an elecronic markeplace. In his ype of markes, i is no surprising o see sellers iniiae he developmen of such sysems. Technological developmens such as he falling cos of elecommunicaions and compuers, or he abiliy o implemen elecronic markeplaces on he Inerne, are reducing boh he fixed and he variable invesmens required o implemen an elecronic markeplace. These developmens will precipiae he inroducion of such sysems in more markes, possibly by lowering he required invesmen o iniiae such a sysem below he hreshold necessary o moivae a buyer or an ouside inermediary. These markeplaces, however, canno succeed n c 19 I is easy o see ha for large enough m and α, αn c >. m Page 17
unless hey can arac a sufficien number of sellers; sellers may ake advanage of his need o hwar elecronic markeplaces conrolled by buyers and independen inermediaries before hese markeplaces can successfully esablish hemselves. As menioned earlier, behavior like his was seen wih he Bargainfinder sysem in he Inerne (Yovovich 1995). Formal modeling of hese sraegic issues is an imporan area for fuure research. 5. Separaing search coss for price and produc informaion Buyers in a differeniaed marke face wo ypes of search coss: he cos of obaining price informaion and he cos of obaining informaion abou he produc characerisics of a seller offering (i.e., he locaion of ha offering in he produc space). In he preceding secions we bundled ogeher hese wo ypes of search coss for price and produc informaion, as has been ypical in he search cos lieraure. Alhough his may be appropriae in some seings (e.g., a buyer may incur a search cos o visi a sore and hen obain boh price and produc informaion), in oher seings i may be possible o separae hese wo coss. For example, a buyer may be able o elephone a sore o obain a price quoe, bu hen may need o visi he sore o obain reliable produc informaion. In his case, he cos of he visi will be separae (and ypically larger) han he cos of he phone call. The abiliy o separae he search coss for price and produc informaion is paricularly ineresing in he conex of an elecronic markeplace. These sysems are unique in heir abiliy o separaely influence he search coss for price and produc informaion hrough appropriae choices in sysem design. In his secion we consider how he equilibrium in model 1 changes if we separae he price and produc informaion componens of search coss. Consider a seing wih n buyers and m sellers similar o model 1, excep ha in addiion o he "fi" cos, buyers face hree ypes of search coss: c 1 is he search cos o visi a seller s we refer o i as he cos of access o s; c is he search cos o acquire price informaion abou he produc offered by seller s we refer o i as he cos of price informaion; c 3 is he cos o acquire informaion abou he produc characerisics of he produc offered by seller s we refer o i as he cos of produc informaion. We assume ha a buyer mus incur he access cos c 1 before eiher he price or he produc informaion can be acquired a heir respecive coss c and c 3. 0 If c = c 3 =0, his seing 0 In his seing, since we assume ha buyer priors are no changing (buyers know he disribuion of seller prices in advance and hey sample wih replacemen), i would never be sequenially opimal for a buyer o revisi a seller; hus we do no need o address wheher he access cos would be paid wice in ha case. Page 18
becomes idenical o he one analyzed in Secion 3.1. Consequenly a equilibrium sellers will charge c 1 and buyers will search unil hey find a seller in heir neighborhood, i.e., a a disance less han c1. However, reducing he cos of price informaion or produc informaion independenly has ineresing implicaions of is own. 5.1. Markes wih Low Cos of Price Informaion We firs consider a seing corresponding o an elecronic markeplace designed o promoe price-shopping. Such a markeplace would make i easy o obain price informaion, bu migh sill require a higher-cos inquiry (such as a visi) o obain deailed produc informaion. 1 A he limi, his markeplace would have c 1 = c = 0 and c 3 > 0, creaing a marke where buyers can learn any seller s price a zero cos, bu hey mus sill "visi" ha seller o acquire produc informaion. As in Secion 3.1, he unique perfec Bayesian equilibrium is symmeric, wih all sellers charging a price p*. The condiion S + D = p* + c from equaion () sill holds; consequenly each seller receives sales from a erriory of lengh c3, consising of he inerval [ c3, c3 ] around ha seller's posiion. Seller i's oal sales are n/m, corresponding o he n/m buyers ha visi i before hey visi some oher seller in heir neighborhood. A equilibrium, here will be no incenive for seller i o deviae by charging a price of p* δ, and equaion (3) will hold as well, i.e., * * d Q p p p dp Q p p * i( i, j i) + * i( i, j i) =0, where Q pi = p* i( pi, p* j i) denoes he sales of seller i i when he price charged by i is p i while every oher seller j i charges price p*. As in model 1, if seller i reduces is price o p* δ, is erriory expands by δ/. However since all oher sellers charge price p*, and since all prices are known o buyers a zero cos, buyers' opimal sraegy is o visi seller i firs. The resul is ha by discouning by δ, seller i will sell o all buyers in is erriory, i.e., o n c3 + nδ buyers. Seller i's incremenal sales (and profis) by discouning are n c n p 3 ( *- δ ) + δ n p ( *- δ )- m p *. I can be seen ha if he 3 number of sellers is large enough so ha n c n >, i.e., m m > 1 c3, discouning will be 1 For example, in mid-1996 a buyer looking for a compuer monior can easily acquire a lis of prices from a large number of sellers by connecing o he Pricewach search engine on he Web (www.pricewach.com), bu hen will face a larger cos in obaining addiional informaion for each produc offering hus idenified. Specifically, he buyer mus obain and evaluae he monior s specificaions, assess he seller s repuaion and reurn policies, and ideally locae a display model a a showroom or a a colleague s office. Page 19
profiable for all p* > 0, and hus he only equilibrium price is p* = 0. In oher words, making prices freely available o he buyers induced Berrand-ype compeiion among sellers. If he cos of produc informaion c 3 is close o zero, his model is similar o Salop s (1979) seing, where sellers can charge a posiive price, which approaches zero asympoically as he number of sellers m grows large. Conrasing our resul o Salop s shows ha he cos of produc informaion relaive o he cos of price informaion can significanly affec he resuling equilibrium: when he cos of obaining produc informaion is he dominan componen of search coss, sellers incenives o discoun increase, as hey will arac inframarginal as well as marginal buyers. If he cos of price informaion c is small bu no zero, here will sill be a corresponding δ = δ( c ) ha would allow seller i o capure is enire erriory by discouning by δ. Since finding i would ake he average buyer m/ ries, we need δ > 1 mc, and he corresponding equilibrium price will be p* = 1 mc ; any price above his would induce sellers o discoun. 5.. Markes wih Low Cos of Produc Informaion Now consider a seing corresponding o an elecronic markeplace designed o promoe compeiion based on produc feaures. Such a markeplace would make i easy o obain informaion abou produc characerisics, bu would require buyers o incur some addiional cos o obain price informaion. For example, high-qualiy mulimedia produc descripions in sandardized formas could help idenify produc offerings maching he buyer's preferences, while price informaion could be lef ou of hese descripions or could be obscured by offering a large number of prices and making i difficul for he buyers o figure ou which one applies. Airline reservaion sysems, for example, make i very easy o idenify a convenien fligh beween a pair of ciies, bu require subsanial effor o idenify he lowes applicable fare. A he limi, his markeplace would have c 1 = c 3 = 0 and c > 0, creaing a marke where buyers can compare produc feaures a zero cos, bu hey face a nonzero cos o acquire price informaion. A he unique symmeric perfec bayesian equilibrium wih all sellers charging price p*, i is now opimal for each buyer is o visi firs he seller wih he bes fiing produc offering, as ha seller can be coslessly idenified, and purchase from ha seller. Individual sellers realize sales of m/n as before, bu heir erriories shrink o an inerval [ 1 m, 1 m ] around heir posiion, which hey compleely dominae. A equilibrium here is no searching on price, complee search on produc feaures, and no inefficiency from imperfec maching of buyers and sellers. The unique equilibrium price is he monopoly price since a any lower Page 0